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Hard Times Inspire Wrong Type of Risk Taking

By Nathan Washburn, Ph.D.

When faced with declining profits and bleak outlooks, one way for executives to respond is through increased risk taking. In fact, researchers have consistently found that executives who find themselves in undesirable situations tend to engage in more risk taking than executives in more desirable situations. Given the current financial environment, more and more executives may look to risk taking as a way to escape disaster.

Traditionally, business risk taking has been considered a good thing — as firms assume more risk, then they are rewarded with higher financial returns. If this traditional thinking is sound, then executives in bad situations should be encouraged to increase their level of risk taking as a way to improve performance. However, a recent study I conducted with colleagues from the University of Miami and Arizona State University found that not all risk taking is the same, and the risks that executives in lower-performing firms take tends to harm, rather than improve, firm performance. In contrast, executives in higher-performing firms tend to take risks that improve performance.

The difference is explained by looking at what motivates these executives to action. In lower-performing firms, executives are motivated by a desire to escape the current situation, but in higher-performing firms, executives are motivated by confidence in their capabilities.

Critical to risk taking success is the ability to sustain effort through challenges and difficulties. When executives are motivated to take risks because of confidence, then this confidence sustains them through the problems that arise. However, when risk takers are motivated by a desire to escape their current situation, they may not have the necessary confidence to sustain their efforts when problems arise. This tendency was illustrated by examining the research and development investment decisions made by executives in high technology firms.

While executives in lower-performing firms tended to invest more in R&D projects, they focused their R&D investments on incremental innovation. In contrast, executives in higher-performing firms invested less in R&D, but when they did invest, it tended to be in more radical innovation. Overall, it was the radical innovations that had the most positive effect on the future performance of the firms in the study.

So, while engaging in risk taking as a way to escape the current difficult circumstances may be a natural reaction for many executives, our research suggests that executives need to be cautious and make sure they have the necessary confidence in their capabilities to sustain their actions through difficult challenges that inevitably arise. If the motivation for engaging in risk taking is to escape a bad situation, the end result is not likely to benefit the firm.

Nathan Washburn, Ph.D., is an assistant professor of management at Thunderbird School of Global Management. He presented his paper, “Past Performance and Organizational Risk Taking,” Aug. 12, 2008, at the Academy of Management annual conference in Anaheim, Calif. Co-authors include Marianna Makri, Ph.D., an assistant professor at the University of Miami School of Business, and Luis R. Gomez-Mejia, Ph.D., a regents professor at the W.P. Carey School of Business at Arizona State University.